B1 FINANCIAL MANAGEMENT NOVEMBER 2016 (NBAA PAST PAPER)
EXAMINATION : INTERMEDIATE LEVE
SUBJECT : FINANCIAL MANAGEMEN
CODE : B1
EXAMINATION DATE : TUESDAY, 1ST NOVEMBER 2016
TIME ALLOWED : THREE HOURS (2:00 P.M. – 5:00 P.M.)
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GENERAL INSTRUCTIONS
1. There are TWO sections in this paper.
Sections A and B which comprise a total of SEVEN questions.
2. Answer question ONE in section A.
3. Answer any FOUR questions in Section B.
4. In total answer FIVE questions.
5. Marks are shown at the end of each
question.
6. Calculate your answers to the nearest
two decimal points.
7. Show clearly all your workings in
respective answers where applicable.
8. This question paper comprises 6 printed pages.
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SECTION A
Compulsory Question
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QUESTION 1
(a)
The Thompton Company Ltd is facing an option to develop
two models of the same product: Model A and Model B. Both models are expected to be hot sellers
for the next two years. The capital
expenditure involved in the development of model A is TZS.2,250 million while
Model B costs TZS.2,500 million. Because of familiarity of the existing users,
Model A which is an improved version of the existing one, it offers a certain
cash flow of TZS.1,400 million in the first year and TZS.1,800 million for the
next year.
In respect of
Model B, Thompton Ltd is not very sure of the cash inflows. It expects a cash inflow of TZS.1,500 million
in the first year with 70% probability.
However, the product may do better to yield a cash in flow of TZS.1,800
million with the probability of 30%. The
cash inflows in the second year are dependent upon what happens in the first
year. If the firm faces a normal cash
inflow of TZS.1,500 million in the first year, the chances are that it would
repeat with probability of 30%, improve to TZS.1,800 million with a probability
of 40%, and do exceptionally well with cash inflow of TZS.2,200 million with a
probability of 30%. If the firm faces
better prospects in the first year, the chances are that it would have second
year cash inflows of TZS.2,200 million, TZS.2,300 million and TZS.2,500 million
with probabilities of 50%, 30% and 20% respectively.
REQUIRED:
Examine both
models and recommend to Thompton Company Ltd which of the two models they
should go ahead with. Assume a cost of
capital of 12%.
(10 marks)
(b)
(i) Explain
how the Capital Asset Pricing Model can be used to calculate a
project-specific
discount rate.
(ii) Discuss the limitations
of using the Capital Asset Pricing Model in investment appraisal. (5
marks)
(c)
Why is it important to know the cost of capital? (5
marks)
(Total:
20 marks)
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SECTION B
There
are SIX questions. Answer ANY
FOUR questions
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QUESTION 2
(a)
In relation to the efficient market hypothesis:
(i)
Briefly discuss its significance to a financial
manager. (3
marks)
(ii)
Explain the differences between the semi-strong form
and the strong form of market efficiency and how each can be tested. (5 marks)
(b)
Mr. Waluwalu is a local entrepreneur doing business in
Dar es Salaam. For long time, Waluwalu
has been considering investing his money in the stock market. He approaches a stockbroker about investing
in stocks. The stockbroker gave Waluwalu
two stock options that he can invest in; Stock X and Stock Y. The stockbroker further tells Waluwalu that
the economy can either go in recession or it will boom. Upon further enquiry Mr. Waluwalu established
that the likelihood of observing an economic boom is two times as high as
observing an economic recession. He also
learnt the following regarding the possible returns of the two stocks:
|
State of the Economy |
Rx |
Ry |
|
Boom |
10% |
-2% |
|
Recession |
6% |
40% |
REQUIRED:
(i)
For each stock calculate the expected returns and total
risk (variance and standard deviation). (4
marks)
(ii)
Calculate the covariance of the returns of the two
stocks. (2
marks)
(iii)
Mr. Waluwalu is considering to create two different
portfolios. Portfolio I consists of 10%
invested in X and the reminder in Y, while Portfolio II has equal proportions
in both stocks. Compute the expected
returns and risk of each portfolio and explain the risk-return characteristic
of each portfolio. (6
marks)
(Total: 20 marks)
QUESTION
3
(a)
Arcadeco Company has the following information:
Current annual
credit sales: TZS.24,000,000
Collection
period: 3
months
Terms: net/30
Cost of funds: 18%
The Company is
considering offering a 4/10, net/30 discount.
It anticipated that 30 percent of its customers will take advantage of
the discount. The collection period is
expected to decrease to two (2) months.
REQUIRED:
Should the
discount policy be implemented? Justify
with computations and interprete your answer. (6
marks)
(b)
Anjali Company has been experiencing fluctuations in
demand for its products the consequences of which is volatility in its cash
balances. Currently, Anjali’s daily net
cashflow has a variance of TZS.10,000.
The yield on marketable securities is 6 percent per annum and the fixed
cost of each transaction in marketable securities is TZS.1,000.
REQUIRED:
(i)
Using the Miller-Orr Model, determine the optimal cash
balance, the upper and lower limit of cash needed and average cash balance
(Assume a year has 360 days). (6
marks)
(ii)
Briefly explain what the firm will do when each of the
limits is reached and/or breached. (2
marks)
(c) Discuss the key factors which determine
the level of investment in current assets. (6
marks)
(Total: 20 marks)
QUESTION 4
(a)
According to Modigliani and Miller (M & M)
theory, dividend policy is irrelevant in a world of frictionless capital
market. How did Miller and Modigliani arrive
to this conclusion? (6 marks)
(b)
Discuss, using appropriate theories, any three
determinants of dividend policy and decisions in real world. (9
marks)
(c)
Crane Ltd. is listed in the local stock exchange. Currently, the company has 2 billion
outstanding shares selling at market price of TZS.100 per share. The company has no borrowing and has internal
funds available to make a capital expenditure of TZS.30 billion. The capital expenditure is expected to yield
a positive net present value of TZS.20 billion.
The firm also wants to pay a dividend per share of TZS.15. Given the company’s Capital expenditure plan
and its policy of zero borrowing, the company will have to issue new shares to
finance payment of dividend to its shareholders.
REQUIRED:
With supporting
computations, explain how Crane Ltd’s value will be affected.
(i) If
it does not pay any dividend
(2
marks)
(ii) If it pays the TZS.15 dividend (3
marks)
(Total :20 marks)
QUESTION 5
(a)
WAMBALI Co. plans to buy a new machine. The cost of the machine, payable immediately,
is TZS.80,000,000 and the machine has an expected life of five years. At the end of the five years, the machine
will have no salvage value and will not be replaced.
Production
and sales from the new machine are expected to be 100,000 units per year. Each unit can be sold for TZS.1,600 and will
incur variable costs of TZS.1,100.
Incremental fixed costs arising from the operation of the machine will
be TZS.16,000,000 per year.
WAMBALI Co.
has an after-tax cost of capital of 12% which it uses as a discount rate in
investment appraisal. The company pays
tax on profit at an annual rate of 30%.
Capital allowances and inflation should be ignored.
REQUIRED:
Calculate and
comment on the sensitivity of the investment in the new machine to a change in
the following variables:
(i)
Sales revenue
(ii)
Sales volume
(iii)
Variable costs
(iv)
Fixed costs
(v)
Economic life
(14 marks)
(b)
(i) Discuss
the nature and causes of capital rationing in the context of
investment
appraisal. (3
marks)
(ii) Explain how this
problem can be overcomed in reaching an optimum investment decision for a
company. (3
marks)
(Total : 20 marks)
QUESTION 6
(a)
Spot Co. is considering how to finance the acquisition
of a machine costing TZS.75,000,000 with an operating life of five years. There are two financing options.
Option 1
The machine could be leased for an annual lease payment
of TZS.15,500,000 payable at the start of each year.
Option 2
The machine could be bought for TZS.75,000,000 using a
bank loan charging interest at an annual rate of 7%. At the end of five years, the machine would
have a scrap value of 10% of the purchase price. If the machine is bought, maintenance costs
of TZS.2,000,000 per year would be incurred.
Ignore Taxation.
REQUIRED:
Evaluate whether Spot Co. should use leasing or
borrowing as a source of finance, explaining the evaluation method you have used
in your calculations.
(10
marks)
(b)
You have observed that two bonds that are listed in the
local securities exchange have different yields to maturity.
REQUIRED:
Critically
discuss the reasons behind the differences in the yields to maturity of the two
bonds. (10 marks)
(Total: 20 marks)
QUESTION
7
(a)
A company currently has annual sales of TZS.500,000,000
and an average collection period of 30 days.
It is considering four alternatives of a more liberal credit
policy. If the credit period is
extended, the company expects sales and bad debts losses to increase in the
following manner:
|
Credit
policy Alternative |
Increase
in credit period |
Increase
in sales (TZS.) |
Bad debts
(% as of total sales) |
|
A |
10 days |
25,000,000 |
1.2 |
|
B |
15 days |
35,000,000 |
1.5 |
|
C |
30 days |
40,000,000 |
1.8 |
|
D |
42 days |
50,000,000 |
2.2 |
The selling price per unit is TZS.2,000, average cost per
unit at current level of operation is TZS.1,500 and variable cost per unit is
TZS.1,200.
REQUIRED:
If the current
bad debt loss is 1 percent of sales and the required rate of return in
investment is 20 percent, which credit policy should be undertaken? Ignore taxation, and assume a year with 360
days. (15 marks)
(b)
Critically evaluate the internal rate of return as a
capital investment appraisal technique. (5
marks)
(Total: 20 marks)
